A. Global Financial Stability

1. Impact of financial crisis. The world economy is slowing rapidly, dragged down by an extraordinary financial crisis, still-high commodity prices, and slumping housing markets in a number of advanced economies (Chart 1). Some emerging market and developing economies are already experiencing tighter financing conditions even as the surge in food and fuel prices feeds through to headline inflation. Further deleveraging, as financial institutions continue to suffer losses, will weigh on credit and activity in advanced countries. Nonetheless, stabilizing commodity markets and a bottoming-out of the U.S. housing market would support the beginning of a very gradual recovery later in 2009. Restoring more orderly conditions in financial markets is the key challenge facing advanced economies and more forceful and coordinated action is needed. In other countries, the challenge for policymakers will be to balance inflation concerns against the prospects of lower growth and the need to preserve financial stability.

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Global Cooling—The global economy is expected to cool significantly in 2009

Citation: Policy Papers 2008, 047; 10.5089/9781498334006.007.A001

Source: WEO(October 2008).

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2. The Fund’s Response. Fund activities are now more focused on the policy challenges raised by the financial crisis, including by strengthening contingency planning and crisis preparedness and stepping up the monitoring of highly vulnerable countries. The Fund’s immediate priorities include contributing to resolving the financial market distress and bolstering the global financial system (see Box 1). In collaboration with other international bodies and standard setters, the Fund is also distilling lessons from the financial crisis and encouraging early action, including through its FSAP assessments, bilateral and multilateral surveillance, and technical assistance activities.¹

• The Fund is actively helping members deal with the current financial crisis, with increasing emphasis being placed on macro-financial linkages (see paragraph 3), contagion risks, financial safety nets, and crisis preparedness and management. Key instruments that the Fund is using to this end include Financial Sector Assessment Program (FSAP) assessments, World Economic Outlook (WEO), Global Financial Stability Report (GFSR) and bilateral surveillance. In addition, the Fund is promoting dialogue within the membership: following consideration of the GFSR² and WEO³ by the Executive Board, these issues were discussed in late September by senior officials from systemically important advanced and emerging market economies in a conference call organized by the Fund. Such an initiative helped promote dialogue and consensus building on required policy responses within the membership, as did a high-level IMF/ Financial Stability Forum (FSF) seminar in early October focusing on risks and policy challenges in the regulatory and supervisory area.

• Policy lessons distilled by the Fund⁴ and by the FSF⁵ underpin a broad consensus on priorities for financial supervision and regulation, with a view to strengthening national policy frameworks and the international financial system. Recommendations that the Fund is encouraging members to implement cover areas such as central bank liquidity frameworks (e.g., frequency and maturity of operations, available instruments, and range of counterparties and collateral to deal with extraordinary situations); crisis management arrangements (e.g., deposit insurance, inter-agency and cross-border information sharing, and bank insolvency frameworks); and encouraging more risk-sensitive capital and supervisory regimes (e.g., reflecting liquidity and tail risk management, and incentive structures for market participants). Other recommendations relate to risk disclosure and valuation (e.g., enhanced requirements under Pillar 3 of Basel II), and the role of—and methodologies used by—credit rating agencies (e.g., lack of transparency and differentiation of ratings for structured products). Also, the Fund’s collaboration with the Basel Committee on Banking Supervision and other standard setters has been enhanced.

• A Fund analysis of how future financial crises may evolve and affect emerging market countries found that higher capital flows have yielded important benefits, but have also increased volatility and potential reversals in capital flows, the risk of asset price bubbles, and the likelihood of crises emanating from the private sector. In addition to reviewing its financing role (see Section I. B.), the Fund’s efforts must therefore aim to: enhance its financial sector analysis, promote better data collection and transparency, tailor technical assistance to bolstering resilience to shocks, strengthen policy advice on crisis prevention and management, and improve communication and coordination with members and international bodies.

3. Macro-financial linkages. The Fund is strengthening the analysis of linkages between the real and financial sectors, a priority for the next few years (see Box 1). A special unit focusing on macro financial linkages is being set up to coordinate work in this area (see Section II). Already, the increasing importance of macro-financial linkages and spillovers has been highlighted in recent Article IV consultations, FSAPs and in multilateral surveillance. For example, the 2008 Article IV consultation with the United States studied the impact of financial conditions on real activity and the impact of hits to bank capital on credit and spending. The latest WEO and GFSR each dedicate a chapter to macro-financial linkages (respectively, “Financial Stress and Economic Downturns” and “Spillovers to Emerging Equity Markets”).

4. Vulnerability exercise. The Fund is expanding its early warning capabilities to advanced countries, as called for by the IMFC in April 2008. One component of this work consists of quantitative indicators—such as asset price inflation, credit growth, and falling corporate and household savings that help signal build-up of medium-term vulnerabilities and the presence of near-term risks. However, the larger part of staff efforts will focus on bringing to bear insights from the GFSR, FSAPs, and cross-country analysis to identify vulnerabilities in individual countries and groups of countries.

5. Bilateral surveillance of external stability. The Fund has also taken steps to implement its new exchange rate surveillance framework more effectively. The adoption of the landmark bilateral Surveillance Decision in 2007 was intended to refocus surveillance on the Fund’s core mandate, including (though not limited to) exchange rate issues. However, making specific and explicit findings in the sensitive area of exchange rates, and grappling with analytical uncertainties have made this task very challenging in a number of cases. A recent review (see paragraph 7) found that while the quality of exchange rate analysis had improved, more needed to be done to ensure candor, evenhandedness and a better integration with the overall macroeconomic policy mix. Steps have been taken to move forward, in particular through the proposed use of ad hoc consultations when there are significant concerns that specific findings are envisaged. Such consultations will provide an opportunity for in-depth discussion between the member and the international community (through the Executive Board), and help the Fund reach conclusions in areas of concern.

6. Exchange rate analysis. The methodological framework underlying exchange rate analysis is being bolstered to strengthen the global consistency of assessments by individual country teams and the assessment of exchange rates in countries posing specific challenges (e.g., non-renewable commodity exporters and low-income countries). A presentation on exchange rate developments and assessments gave the Executive Board an opportunity to discuss these issues from a multilateral perspective. The staff’s analysis focused on three aspects: the evolution of real effective exchange rates in relation to their fundamental- adjusted period averages; the shifts in current account balances needed to stabilize net foreign asset positions; and the changes in real exchange rates needed to eliminate gaps between current account balances and their equilibrium (norm) values. A further discussion of exchange rate issues from a multilateral perspective is planned in the context of a forthcoming review of countries' choice of exchange rate regime, and how it affects the efficient functioning and stability of the overall system of exchange rates.

7. Review of Surveillance. A thorough review reached a generally positive assessment of surveillance, but confirmed the need for deeper analysis of global stability risks, as is already underway. The recently concluded triennial surveillance review (TSR)⁶—a detailed stock-taking exercise involving broad consultations and an independent evaluation component—suggested that Fund surveillance is held in high regard by its key audiences. Progress is evident on many fronts: beyond exchange rate analysis, mentioned earlier, surveillance is more sharply focused; and cross- country spillovers and financial sector surveillance have been receiving greater attention. However, it is clear that more needs to be done to improve the effectiveness of surveillance, building on the Fund’s comparative advantage in the analysis of global financial markets, the incorporation of multilateral perspectives and the assessment of tail risks, real-financial sector linkages, and global spillovers, including external stability. As noted earlier, work is well underway in these areas. To steer surveillance further in this direction over the next few years, the Executive Board recently adopted a first ever Statement of Surveillance Priorities⁷ (See Box 1).

8. Sovereign Wealth Funds (SWFs). An international working group, supported by the Fund, reached a preliminary agreement on a set of 24 generally accepted principles and practices (GAPP), also known as the Santiago Principles. Recognizing the growing importance of SWFs in international financial markets and to foster better understanding of SWFs, an International Working Group (IWG) of SWFs was created in April 2008 with the aim of putting together a set of voluntary generally accepted practices and principles for SWFs by October 2008. The Fund facilitated and coordinated the work by providing a secretariat and supporting the discussions among the IWG members.⁸ The GAPP covers practices and principles in three key areas: (i) legal framework, objectives, and coordination with macroeconomic policies; (ii) institutional framework and governance structure; and (iii) investment and risk management framework. The development of the Santiago Principles is a significant step as it is the first time SWFs have set out the elements of a comprehensive collective framework to inform and guide their institutional frameworks, governance structures and investment decision-making policies. The Santiago Principles seeks to help maintain the free flow of cross-border investment and sustain an open and stable financial system. By embracing the Santiago Principles, SWFs could reduce concerns and thereby help to mitigate the risk of protectionist pressures on their investments and restrictions on international capital flows. At the same time, the OECD initiative on recipient country policies toward SWFs, which is progressing, will also help to ensure that recipient countries remain open to SWF investments.

B. Fund Lending Role in a Globalized World

9. Fund financing. Demand for Fund facilities shrank in recent years, reflecting higher private capital flows as well as other factors such as strengthened policy frameworks and substantial debt relief (see Tables 5 and 6 for current arrangements and balances). However, lower demand for Fund resources may also reflect the need for facilities to adapt. While the Fund currently has tools to help members meet balance of payments needs, adjustments may be necessary to address concerns that the Fund’s instruments are not always tailored to provide the services members seek, and that they send negative signals about prospects, come with too many conditions, provide too little financing, and are too costly. And the Macro-Financial and Cross-Border Risks study noted above identified new sources of risk that could affect members’ balance of payments needs. In taking up these broad issues, the Review of the Fund’s Financing Role in Member Countries⁹ recognized that the Fund’s lending framework has been used flexibly on a case-by-case basis, striking a balance between adjustment and financing while playing a catalytic role. The review is at an early brainstorming stage, seeking Executive Directors’ views on potential new instruments; elimination or reform of rarely used instruments; and a range of other issues related to the rationale and modalities for Fund lending.

10. Road map for reforms. An initial discussion led the Executive Board to endorse a road map for reforms involving five work streams: (i) analytical considerations for Fund lending, looking at a range of issues such as market gaps, the coherence of the Fund’s lending framework, the balance of payments criterion for Fund lending, as well as the scope for innovation in and streamlining of instruments, including a possible extension of a PSI- like signaling instrument to other members; (ii) access limits and financing terms for using Fund resources; (iii) conditionality; (iv) lending role and facilities for low-income members; and (v) a new liquidity instrument for crisis prevention. The aim is to have Board discussions in all of these areas before the 2009 Spring Meetings and to take decisions as quickly as possible in those areas where there is a strong consensus and particular urgency (e.g., a liquidity instrument). After the Spring Meetings, a stock-taking exercise will determine how to pull all the building blocks together to set the stage for decisions in the remaining areas before the 2009 Annual Meetings.

11. IMF lending limits. The Executive Board will shortly consider again aspects such as the amount of financing normally available and the cost of Fund credit. The recent quota reform made important progress in realigning quotas—which determine how much a country can borrow from the Fund under normal circumstances (access limits)—for emerging markets that have grown rapidly (see Section II), but overall access has fallen substantially in the last decade relative to global output, trade, and capital flows. The Fund will assess whether higher normal access limits are warranted. After the Annual Meetings, proposals to simplify the system of interest rate surcharges—for large-scale borrowing and some cases of resources outstanding for a length of time—will be considered. These proposals, together with the framework for setting the rate of charge under the new income model agreed before the Spring Meetings, will provide a new pricing structure for Fund lending.

C. Food and Fuel Price Spikes

12. Impact and policy response. An early assessment considered the causes and likely macroeconomic impact of higher food and fuel prices, and advised on policy responses.¹⁰ Much higher food and energy prices threaten to undermine macroeconomic stability through higher inflation, import costs, and fiscal outlays (Chart 2); slow or reverse poverty reduction gains; and jeopardize food security for many. While the impact is likely to be greatest on low-income members, higher prices can pose macroeconomic challenges for all countries, including for inflation targeters seeking to maintain credibility. An updated assessment prepared in September shows that oil and food prices have recently fallen from their 2008 peaks, but remain volatile, and the effects of still-elevated prices on the balance of payments, budgets, and inflation have intensified. About 50 low- and middle-income countries are expected to remain vulnerable through 2009. There has only been limited use of nominal exchange rate flexibility as a shock absorber, and in addition to other fiscal measures, a number of countries have increased public wages.¹¹ A study of fuel and food subsidies found that these have risen since 2006 and are likely to increase further, with substantial fiscal costs and spillovers such as higher global demand.¹² Policy responses recommended in these papers include:

• passing through international prices, in a gradual manner if needed, and using targeted measures to protect the poor rather than universal subsidies; setting monetary and fiscal policy to limit second-round price effects and generalized inflation;

• expanding social safety nets consistent with fiscal and external sustainability, and combining this where necessary with offsetting actions (e.g., steps to raise revenues, cuts in lower priority spending, and mobilization of additional external assistance);

• allowing real exchange rate depreciations for net food and fuel importers facing permanent shocks (while being mindful not to stoke inflationary pressures); and

• discouraging export taxes and bans, while encouraging lower import tariffs.

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50 countries are under pressure due to rising food or fuel prices

Citation: Policy Papers 2008, 047; 10.5089/9781498334006.007.A001

Source: WEO. 2008 projections compared with 2006.

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13. IMF financial support. The Fund is also providing additional financial support in response to higher food and fuel costs and enhancing its ability to respond flexibly to such external shocks. So far in 2008, a significant number of low-income countries have benefited from Fund financing to help deal with balance of payments pressures mainly from higher food and fuel prices. Eleven countries have received SDR 128 million or about $200 million in additional assistance under existing lending programs supported by the Poverty Reduction and Growth Facility (PRGF). Five new PRGF arrangements providing access of SDR 176 million or about $274 million to help in part with commodity price shocks have been approved. Still other countries have received financial support through the Fund’s emergency assistance to help cope with the impact of recent natural disasters.

14. Coping with shocks. In September, acknowledging the importance of moving ahead in light of worsening global economic conditions, the Executive Board approved a revamping of the Fund’s Exogenous Shocks Facility (ESF) to make it more useful to low- income members. The changes will enable the Fund to provide more rapid and effective assistance in the event of shocks, with faster disbursements based on up-front policy commitments and streamlined procedural requirements (e.g., development of a Poverty Reduction Strategy would not be required).¹³ With the reforms, countries would not have to give up a Policy Support Instrument (PSI)—which many countries prefer to maintain—in order to obtain ESF funding. Consents are needed from PRGF-ESF Trust lenders and contributors to effect the changes.

15. IMF role in LICs. Responding to food and commodity price shocks is only one aspect of the Fund's broader engagement in low-income countries (LICs). The Fund reaffirmed the need for close engagement with low-income members on key challenges such as those related to commodity prices in a review of the Fund’s role in LICs.¹⁴ The review noted that many countries have made progress toward macroeconomic and financial stability, which is central to sustained growth and poverty reduction. The Fund’s approach evolved too, e.g., with greater flexibility in inflation and fiscal targets, and greater focus and parsimony in Fund conditionality on measures critical for macroeconomic stability. The need for continued close and tailored engagement with low-income members was emphasized, with the main channels remaining policy advice, capacity building assistance, and concessional balance of payments support.

16. Strategy in LICs. The Fund will focus on its core expertise to help LICs achieve and maintain macroeconomic and financial stability and avoid a new unsustainable debt build-up. An agenda for moving forward with concrete actions to help respond to the pressing needs of LIC members is outlined in a statement by the Managing Director that follows up on the Board discussion of the Fund’s role in LICs.¹⁵ The Fund’s efforts, including building capacity for the development of medium-term debt strategies, support country-owned development strategies that seek to absorb higher levels of aid and accelerate progress toward the MDGs. The Fund will also draw on cross-country experience to help strengthen policies and institutions. As a growing number of LICs move toward middle-income status and grapple with challenges related to financial market development and expanded financing opportunities, the Fund will keep adapting its support to them, including with a review of the PSI and as part of the broader Review of the Fund’s Financing Role described above. Regarding fragile and post-conflict states, a proposal for strengthened engagement will be refined. The Fund will continue to collaborate closely with other institutions—as it recently has for example through the UN High-Level Task Force on the Global Food Crisis, an IMF- OECD-World Bank workshop on food and fuel prices, and through the UN MDG Africa Steering Group.